A paradox lies at the heart of the financial advice industry: the professionals we trust with our life savings are among the highest-paid yet among the least trusted in our economy, with significant records of misconduct within their ranks.
While advisors should always prioritize client-investment fit, the reality is that they are incentivized to recommend certain products over others, not necessarily to act in their clients’ best interests, said Professor Simon Gervais of Duke University’s Fuqua School of Business.
“The temptation comes from the fact that when they sell ‘specialized' products, they receive a commission,” Gervais said.
A “specialized product” — an investment mix featuring higher-risk, higher-reward financial assets (think of stock options, or cryptocurrencies) — may not be the right choice for people with a risk profile more suited to more standard investments (think of index funds).
In the working paper, “Ethics and Trust in the Market for Financial Advisors,” Gervais and John Thanassoulis of the University of Warwick, UK, found that investment funds maximize their profits by offering bonuses — commissions — to the advisors who sell risky products to their clients.
In doing so, they incentivize misconduct, the researchers found, especially in the later stages of an advisor’s career, when the consequences of a tainted record are less likely to hurt their reputation and lifetime earnings.
A theoretical model rooted in empirical research
Gervais said past research was “eye opening” in showing a pattern of widespread misconduct.
“There is more misconduct than we thought, despite the data being publicly available,” he said.
“We know that advisors, when they are caught, typically remain in the industry and move to different firms, some of which seem to specialize in hiring them. Also, there is more misconduct as advisors get older.”
Previous research suggests that between 2005 and 2015 in the US, “over 12% of financial advisors acquired a misconduct record” and in some firms, “one in five of employed advisors have been guilty of misconduct; these include some of the best-known banks in the United States,” the researchers write.
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Gervais and co-author wondered why misconduct is so pervasive, despite advisors being among the highest paid professionals and despite their incentive to maintain a clean record.
The researchers built a model for the financial advisor market, where investment funds pay higher commissions to advisors who sell their clients highly sophisticated products.
In this market, financial advisors who build an “unblemished” reputation at the beginning of their career tend to acquire more clients. However, they are more tempted by commissions later in their careers, when losing potential clients would have less impact on their accumulated wealth.
The researchers also assumed that regulators had varying degrees of effectiveness when pursuing misconduct, thereby increasing or reducing the incentives in this market.
According to this model, the investment fund maximizes its returns by paying certain levels of commissions — which incentivize the misconduct of “unethical” advisors.
Unethical advisors take advantage of the system of incentives by initially building a clean reputation and then increasing misconduct in their later years.
The model finds an equilibrium with commissions and some level of misconduct. If regulators start catching more unethical advisors, all the fund needs to do is to offer bigger commissions, Gervais said.
“The funds understand that with the proper convincing, they can buy the advisors’ ethics. There's a price to buy them. And the price of these ethics goes up when the probability of getting caught increases” he said.
Why is public data not enough for consumers
Financial advisor records are publicly available through FINRA, the Financial Industry Regulatory Authority that oversees brokerage firms.
But for ordinary people shopping for an advisor, sifting through the public records of misconduct is not easy, Gervais said.
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“Searching is demanding, because this data is not easily accessible and usable,” he said.
Usually, people rely on their friends and network for recommendations, which reduces the chance of picking a questionable advisor, Gervais said.
Are financial advisors useful?
Ordinary investors may face a trade-off between the peace of mind of a “passive” index fund versus the services of a financial advisor, who may try to chase higher returns.
For people with low annual income, “there isn’t much more an advisor can do for you” Gervais said. “Nothing more than what a passive index fund could do.”
(Many experts agree that in the long run, when you account for the fees of actively managed investments, index funds actually outperform active funds.)
However, financial advisors are useful for a host of reasons beyond driving returns, Gervais said.
First, “many people without financial advisors do weird things,” he said, and paying a fee may be a reasonable — albeit expensive — price for protecting you from bad decisions.
“I know a financial advisor who manages the money of some artists and professional athletes,” Gervais said. “Many of these clients want to open their own restaurants, which are oftentimes atrocious investment choices, as the lack of diversification means that they could lose tons of money. So, the role of an advisor is simply to say why this doesn't make sense.”
He also said that advisors are useful for making people feel “less scared” of investing in general, and helping them think about taxes, insurance, “and about passing their money to their kids or spouses when they die.”
How to contain misconduct
Gervais said it is not always straightforward to pinpoint what constitutes “bad” investment advice. Sometimes, even successful investment strategies may be the result of bad advice.
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“You're 90 years old. You've got money to live until 105, and the advisor tells you to take a big risk — of course this is inappropriate,” he said. “Even if that year your money doubles, it should still be considered misconduct on the part of the advisor, because that recommendation to a 90-year-old is clearly a bad one.”
Even though gathering data on reputable advisors is not easy, consumers can help themselves by asking their advisors what their incentives are for recommending specific products, Gervais said.
“If an advisor is very good, they're not going to be insulted if you ask them ‘how do you get paid from this decision that I'm making?’” he said.
“The other thing I would try is to ask them about the financial products that they themselves buy,” Gervais said.
However, the researchers found that what may matter most in deterring misconduct is a stronger regulator — with more powerful capabilities of detection.
As their model shows, when the probability of getting caught becomes too high, the investment fund would lower or eliminate commissions, taking away some of the motivations for misconduct.
“If the regulator gets better and better and gets sufficiently good at some point, then these funds will say, ‘All right, I give up, because now it's becoming too costly to convince people to cheat,’” Gervais said.
But the problem is not an easy one to solve, he said, as more pressure from the regulator “would likely only delay the misconduct of unethical advisors, who would then wait until later in their career to take advantage of their reputable record.”